Wednesday, November 01, 2006
Self fulfilled prophecy
This is one of the most highly debated topics in the finance industry, it involves not just stocks but any commodity where the price can be accurately charted with sufficient volume. Buying and holding a well positioned stock with good earnings growth should obviously lead to higher valuations for the stock years down the road; that is of course all things being equal and stocks selling for a general price/earnings range. If there was a specific P/E value that all stocks should sell for then this would make technical analysis essentially worthless and make investing with just the fundamentals the new “trend.”
Many people, it seems to be mostly the older investors, hate technical analysis. Technical analysis to an old value investor is like voodoo to a priest. Many people believe that indicators such as trend lines, relative strength indexes or moving averages only work because EVERYONE uses them. Now this could be the case, if everyone used the same indicators the market would move in very choppy patterns between two values. Up and down like a graph of your heart beat. I am a strong believer that technical studies have more going for them than that they just work because so many people use them.
Technical studies chart how the price moves rather than what news or fundamental piece of information makes an investor buy or sell a security, equity, commodity, or even things on ebay. (Ebay is great!)
I believe technical studies accurately determine where prices will be going. Watching technicals should be a very important part of your investment research. I will talk about the easiest but often most important technical study, the trend line.
Below is a chart of Google Inc: 
There are many key trend lines in this chart but the two most crucial are the two red lines. These lines draw a nearly perfect tunnel which Google has followed since its IPO. The stock did break through to the upside, but this can never been seen as a bad thing regarding its strength. That just shows how powerful the buying was behind the stock.
The bottom red line has yet to be beaten by the price. It has been tested three times but it has never given to the downward force. (Downward force, sounds like something out of Star Wars)
The top line has been destroyed on four occasions, but is showing its strength in the recent peak. This line is weaker, but this is not a problem. It just demonstrates how much stronger Google is to the upside rather than in the selling. Google can crush the upward trend but doesn’t buckle when testing new lows.
Trend lines can be used horizontally too. Important, round numbers such as 500 or 525 tend to show the most support or resistance because that is the location where most people place their stop or limit orders. This was discussed in a previous blog post about why we tend to like these numbers more, its titled “Dow 12000, but what do these numbers mean.”
Trend lines best display the slope of the advancement or decline in a security. The older the trend line, the stronger it is. Usually when trend lines have never been broken they are stronger to future attempts to cross the line. Trend lines that have been compromised usually do make good market indicators but show a weak support or resistance rather than a much stronger, unbroken line.
While it is true that stocks can be manipulated by such self fulfilling prophecies, simple technicals like trend lines are not fueled by the masses who use them. Trend lines are in the simplest form a line at which an investor expects a security to advance or decline. Technicals are neither witchcraft nor the end all solution to investing.
Look to start drawing trend lines in your stock charts to help give you an idea of where a stock will be headed. The returns of your portfolio will increase substantially by utilizing trend lines to their full advantage. To get ahead of the game you must do something that most people do not; using trend lines is a perfect way to obtain the advantage.